Week 06 - Discussion

Posted on: 11th May 2023

Question

Consider the following scenario:

You have just inherited a small island in the Bahamas. The island is near a favourite fishing location, and you are considering two alternative investments.

• First, you could construct a boat landing that provides grounds for camping. You estimate that the landing will require a £1,000 investment today and that it is expected to generate cash flows of £1,000 per year, forever.

• Alternatively, you could invest £10,000 today and build a restaurant and ‘beer garden’, which you believe will then generate cash flows of £4,000 per year, forever. You cannot undertake both businesses on the island (they are mutually exclusive), and since both rely on tourists, you believe that the riskiness of each venture is identical (you may assume this to be the case and that the associated required return is 20%). A quick calculation shows that the IRR of the first alternative is 100% and that the IRR of the second alternative is 40%. Hence, according to the IRR criterion, the first option is preferable.

In approximately 1,000 words, address the following, each in a separate paragraph:

• Do you agree with the assessment?

• Provide alternative capital budgeting evaluations of the two projects and discuss which method is the most reliable. • Also discuss what other factors should be taken into consideration. Be sure to articulate the strengths and weaknesses of each te

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Solution

Week 06 - Discussion

Introduction

Since it is hard for the internal rate of return to completely convey the choice of the kind of investment to the trail, I do not agree with the scenario in the assessment. The reason as to why the internal rate of return cannot solely be a determinant factor is because the IRR tool for making decisions is not the right tool to gauge the reciprocally independent projects as in the scenario (Atrill, McLaney and Harvey 2014, pg. 63). The tool used is useful when rating individual projects. On the other hand, IRR usually overstates the equal yearly rates of return in which their interim cash flows are invested for the second time at a lesser rate than the earlier calculated IRR. A con associated with IRR is that it does not consider the capital structure. Moreover, it often gives multiple values in the occasions whereby there are differences in cash flows.

Analysis

Alternative Capital Budgeting Evaluations of the Two Projects

1. Payback period

In the course of applying this technique, cash flows are not discounted. When it comes to investment one, the payback period is one year because the project has an initial investment of $ 1000. Also, this amount is expected to produce cash flows amounting to $1000 annually. Therefore, in this method, it is going to take a year to identify the cash units that have been invested. Regarding the second investment, the duration for payback will be two and a half years. The calculation for this case will be as follows: The primary investment is $1000. After two years, the cash flows will be $8000, and in the next half year, the cash flow accumulates $2000.

Conclusion and Recommendation

When considering the two projects, the most reliable method will be the first alternative. The reason for choosing the first alternative is because it has the lowest duration as compared to the second alternative.

2. Net Present Value

Net present value is another capital budgeting evaluation that can be applied to the two projects. Here, the initial investment for the first alternative is $1000. Since the total Present Value (PV) =Cash flow/Discounting rate (Atrill & McLaney 2016, pg 23).

Therefore, PV=$1000/0.2

=$5000

NPV = (PV- Initial outlay)

         = 5,000 – 1000

         = $4,000

Regarding the second alternative, the initial or rather primary investment is $10000

Total PV= Cash flows/Discount rate

Therefore = 4,000/.2

                               = $20,000

Net Present Value is calculated by PV-Initial outlay= $20,000-$10000

= $ 10,000

Conclusion and Recommendation

When using this method, alternative two is the most reliable as it has the highest net PV of $5000

3.  Profitability Index (PI)

Profitability Index is also another alternative that can be used in capital budgeting for the two projects. In alternative one, PI=PV of cash flow/Prevent value of the cash flow

= $5,000/1000

    = 5

On the other hand, Alternative two will be calculated as PI = Present value of cash inflow/ Prevent value of cash outflow

    = $20,000/$10,000

   = 2

Conclusion and Recommendation

Alternative one will be the most reliable as it has a higher PI than alternative 2, 5 and two respectively. Considering all the above methods, Net Present Value is the most reliable technique of capital budgeting evaluation. The reason for choosing this approach is because it involves cash flows throughout the entire process. Moreover, it also considers the discounting cash flows in the course of presenting values.

Other Factors to be taken into Consideration

1. Political and cultural factors

Studies have shown that politics greatly contribute towards either the success or failure of business operations. Culture too is critical especially in determining demand, and thus the two factors should be evaluated before venturing into a business (Atrill & McLaney 2016, pg 162).

2. Risks involved

In deciding on the best option for investment, capital security is a critical issue to be considered so that all the necessary risks are avoided (Atrill & McLaney 2016, pg 162).

Net Present Value

Strengths

NPV has several strengths. First, investment options can be easily compared if the method is used. It allows for comparison as it discounts all the opportunities for investment using an equal rate. Also, this technique can inform on profit or losses (Biondi & Zambon 2013, pg. 44).

Weaknesses

On the other hand, it is also associated with a few risks. One of the risks is that the method is sensitive when it comes to discount rates. Also, different level of risks affects the method (Atrill & McLaney 2016, pg 25).

Payback period technique

Strengths

The method is simple and can be easily used in evaluating projects providing faster returns (Atrill & McLaney 2016, pg 30).

Weaknesses

Some of the weaknesses associated with this method are that it does not consider the time value of capital. Also, the technique does not consider cash flows from a project that might start after the primary investment recovery (Atrill & McLaney 2016, pg 31).

Profitability Index

Strengths

The method has several strengths. One of the strengths is that it is easy to understand and also deriving its calculation. Also, it employs the use of cash flows and does not account for the returns. Moreover, this method takes into consideration the analysis of all cash flows through the business transaction process (Mumba, 2013, pg. 11).

Weaknesses

Despite the strengths, the method has several weaknesses. First, it needs forecasting cash flows, and secondly, it is challenging to calculate PI when two projects are having varying useful life (Mumba, 2013, pg. 11). 

References

Atrill, P., & McLaney, E. J. (2016). Accounting and finance for non-specialists 5th edn. Harlow: Pearson.

Atrill, P., McLaney, E. and Harvey, D., 2014. Accounting: An Introduction, 6/E (Vol. 6). Pearson Higher Education AU.

Biondi, Y., & Zambon, S. (2013). Accounting and business economics: insights from national traditions. New York, Routledge. http://site.ebrary.com/id/10643532.

Mumba, Cryford. (2013). Understanding Accounting and Finance Theory and Practice. Trafford on Demand Pub.

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